Do Low Rates Thwart Recovery?

On the eve of the Jackson Hole Fed gathering, the San Francisco Reserve Bank Chairman, John Williams, has launched an enlightening debate on the challenge raised by protracted natural interest rates. The so-called r-star would rank now close to zero in the US and below that threshold in the Eurozone.Williams claims central banks’ short-term money pricing can barely influence natural rates, whose sweeping decline over the last decade stems from key structural weaknesses in the economy. Low growth and poor productivity performance drive down inflation and rate expectations, depressing the levels of current expenditure. He joins Larry Summers in warning about the danger of secular stagnation unless a robust policy mix fully embodying long-term objectives is implemented. But, more crucially, he flatly points to flaws in monetary policy in tackling such a sharp slide.

Extremely low r-star levels imply that conventional monetary tools have little room to stimulate the economy. Even off-the-way measures may prove ineffective in the event of entrenched muted inflation and growth, fuelled by downward prospects. According to John Williams, breaking such a deadlock would call for a higher inflation target coupled with an overhaul in the way the Fed tailors this objective. A move towards nominal GDP targetting would trigger a more aggressive stance whenever the economy falls prey to low-grade growth or markedly less intense price levels.

John Williams’ reasoning mirrors the growing concern policymakers have about monetary policy’s shortcomings in supporting recovery. Introducing targets better fitted for tackling low natural rates seems fully warranted. But, as he acknowledges, running a looser policy may fail to revert the current r-star trend. At the end of the day, one is bound to recognize that the real problem lies in declining expenditure levels. So lowering the saving ratio becomes a must. But this goal is only attainable if the social safety net secures better perspectives for people’s future. Otherwise, they will resort to saving a higher proportion of their current income. Investing in education, enhancing the job outlook and guaranteeing decent public pension schemes all play a crucial role in delivering such an outcome.